This post is about Individual Retirement Accounts, IRA’s. There are several types and the discussion comes up a lot as to which IRA is best for the high earning healthcare professional.
The ones which I’ll discuss are:
- Traditional IRA’s
- Roth IRA’s
- SEP IRA’s
- SIMPLE IRA’s
What you do with the money in an IRA account is much more important than having an IRA.
If someone asks what you’re invested in then you wouldn’t say “IRA’s”.
The term IRA designates an account to be tax-favorable per the IRS. If you have investments in an IRA then you are either deferring taxes on those contributions into the future or paying no taxes as the investment grows.
IRA & Tax Considerations
IRA’s offer tax advantages in several forms depending on your circumstances:
- tax deduction on initial contribution
- tax-free growth
- tax-free withdrawal
The IRS allows certain individuals, depending on their income and a few other factors, to deposit money into an IRA without having to pay taxes on the contributed amount.
The pre-tax contribution in a Traditional IRA would also lower the amount of money on which you would owe state/federal income taxes.
While a Traditional IRA can be tax deductible, a Roth IRA is never tax-deductible.
This pre-tax money can then grow tax-free without you owing any ongoing taxes on dividends or fund appreciation. In fact, even if you buy and sell within your IRA account, you wouldn’t owe any taxes on profits.
It’s possible to have a large Roth IRA balance coming up on retirement and not pay any income taxes from the qualified distributions from that account.
If I meet the IRS’s age criteria and the account’s maturity age of at least 5 years then I can withdraw money from a Roth IRA without paying any state or federal income taxes.
1. Traditional IRA
You open a Traditional IRA at a bank or a brokerage company and this institution is called the custodian. You will see that some will choose to open their Traditional IRA at their Bank of America branch while others will open it at Vanguard.
Depending on the custodian’s offerings, you’ll have an array of investment options. Some custodians will get pretty fancy and let you even invest in real estate and peer-to-peer lending notes etc.
Anyone can contribute to a Traditional IRA – keep this in mind.
As of 2018, you can only contribute $5,500 to your Traditional IRA.
Criteria for Contribution
Anyone who has enough income can contribute to a Traditional IRA. No income, no contributions. You could be earning $10M a year and you can still contribute to a Traditional IRA.
So if you are paying your 10-year-old an income then they can contribute all of that to their Traditional IRA. Imagine setting $5,000 aside a year from the age of 10 until you turn 70 – wow.
If you make a low enough income then you can qualify to deduct the entire Traditional IRA contribution amount from your taxable income. If you earned $55,000 and contributed $5,000 to your Traditional IRA then you would have paid income taxes on only $50,000.
Your investments will grow tax-free within the IRA as I discussed above. Whether you are receiving interest on a peer-to-peer note or a CD or whether you are getting dividend income or selling appreciated funds (capital gains) within the account, none of this would create a tax event for you.
Taxes are deferred, not expunged. This is an important fact because even though your qualified Traditional IRA contribution would come from pre-tax dollars, eventually you would have to pay income taxes on that money such as in the case when you go to withdraw it in your retirement years.
For those with high incomes such as physicians, you can still contribute to a Traditional IRA but you would be forced to contribute with after-tax dollars. This money would still grow tax-free but you would be forced to pay taxes on the money again when you withdraw it during retirement unless you have documentation to prove to the IRS that the money came from after-tax contributions.
Another tax advantage is that you can convert some of your pre-tax Traditional IRA into a Roth IRA which means that you wouldn’t have to pay any income taxes on the withdrawal during retirement. Doing so could create a tax event unless you are in a low enough tax bracket and have enough deductions to sneak out of it. This requires some planning but is worth considering.
2. Roth IRA
The Roth IRA has the well-known benefit of creating no tax event for the retiree. This can make tax planning a breeze. If I have $100k in my Roth IRA then $100k of that money is available for me to use during my retirement, assuming age 60+.
Another easily overlooked aspect of a Roth IRA is that it doesn’t have the Required Minimum Distribution (RMD) clause which Traditional IRA’s do; once you turn age 70 you are forced to take withdrawals from your Traditional IRA but not from your Roth IRA.
Read the Godfather’s post on Roth IRA’s which is the most concise description of it that I’ve found.
As of 2018 you can only contribute $5,500 to your Roth IRA, same as the Traditional IRA.
The major disadvantage of a Roth IRA is that eligibility to fund a Roth IRA phases out as your income goes up. Somewhere in the $120k+ income range your ability to contribute to a Roth IRA disappears.
From all the different IRA’s which I’ll discuss in this post, the Roth IRA is the only one which will be 100% tax-free upon withdrawal.
You can convert your 401k to an IRA and then to a Roth IRA but realize that this is a taxable event. Anytime you convert a Traditional IRA into a Roth IRA, the amount that’s converted would be considered income and you would owe ordinary state and federal income taxes on it.
3. SEP IRA
A SEP IRA stands for Simplified Employee Pension Individual Retirement Arrangement. SEP IRA’s are used by business owners to set aside more than what’s allowed by a Traditional IRA into retirement accounts.
The average Urgent Care physician will be able to stash more aside in a solo 401k than a SEP IRA which is why a SEP IRA isn’t as exciting to me but it can make sense in the right circumstances.
One obvious factor is that a SEP IRA is really easy to establish while a solo 401k requires a bit of paperwork.
One important note of a SEP IRA is that if you set one up for yourself and you have employees then you must offer them the same benefit. If you prefer not to do that then it would make more sense to open a Solo 401k.
The maximum annual amount that can be contributed is $54,000 as of 2017. This is based on 25% of the employee’s income – which means that they would have to earn a gross of $216,000 in order to max out the $54k limit.
If you are the owner/employee of your business then you are limited to about 18.6% and again maxing out at $54,000 of total SEP IRA contributions.
Just like any other IRA, depending on the brokerage or custodian of the account, you can invest in anything that’s permitted by the IRS which is a pretty wide range of investments.
The same tax rules apply to a SEP IRA as to a Traditional IRA. The money goes in pre-tax, grows tax-free, and you would owe federal/state income taxes on the money upon withdrawal.
4. SIMPLE IRA
A SIMPLE IRA stands for Savings Incentive Match Plan for Employees Individual Retirement Account. It is generally something that an employer provides for their employees so it won’t be very relevant to the self-employed physician.
Its low contribution limit (~$12k)has made it an unfavorable retirement option especially now that 401k’s are ubiquitous.
As of 2017 the contribution limits are $12,500/year and the vesting rules are simple unlike a 401k which can require an employee to work for a few years before vesting.
The criteria are simple, if you’re an employee then you qualify for a SIMPLE IRA if it’s offered by your employer.
There is also a mandatory employer contribution which can be as low as 1% or as high as 3%.
The Big Picture
When it comes to IRA’s it’s important to understand the tax advantages of a Traditional IRA versus a Roth IRA. Beyond that it’s unlikely for the average healthcare professional to use a SEP or SIMPLE IRA since an individual 401k, aka solo 401k, is a much better option.
As physicians we can be both employer and employee and generally contribute higher amounts to our solo 401k’s than to other IRA’s.
Even after maxing out our solo 401k’s we can still contribute to a Traditional IRA and a few of us might qualify for a Roth IRA.
Another topic that’s important to consider is whether and when to convert some of your Traditional IRA into a Roth IRA in order to get rid of the RMD’s and create a more favorable tax planning situation.
I am not a fan of the backdoor Roth IRA but the Godfather has written a lot of helpful posts on it and if it’s right for you, cheers.